Why be an active investor?

'plus ça change, plus c'est la même chose'

The great paradox of active investing is that whilst active investors in aggregate do not beat the market their decisions lead to more efficient allocations of capital, on the whole, in the long run. 

Therefore the generally accepted mantra for small time investors or those allocating their pension contributions is to go for low cost passive index funds and/or ETFs.  Even everybody's favourite investor Mr Buffet says the best option is low cost index funds. These allow you to hold the whole market at a much lower cost than a traditional actively managed fund.

This makes perfect sense. Confession: I had most of my defined contribution pension fund in passive funds when I worked for a major active fund manager!

The merits of this passive strategy are well known and quite apparent. But what happens if everybody does this? Or at least the great volume of market activity and liquidity is generated by funds investing at the index weight be they passive unit trusts or ETFs.

Arguably what happens is the market becomes increasingly inefficient with increasingly numerous opportunities for active investors to make some time honoured alpha.

ETFs in particular seem to offer a greater systemic risk as they are so readily tradable. Many pension investors making monthly contributions with a large passive house like L&G will seldom trade their funds or give any thought to asset allocation.

However ETFs are by their nature a product for trading and the AUM has grown hugely during the last 8 years since the financial crisis. The impact of a surge of liquidations on the market is as yet untested. But if and when it does happen I should expect some excellent opportunities to acquire high quality companies at significantly mispriced levels and I suspect we may end up with liquidity and / or capitalisation driven factors dominating the market over expected return and more traditional valuation metrics.

Now one could argue that aligning one's investment approach with those flows would be beneficial. But only to a point. As stocks being proportions of a business pay things out like dividends - and an extreme sell off by passive funds could lead to the most illiquid falling furthest offering ripe pickings with extremely high yields.

With this in mind I shall continue to shine a torch for the active investor. Opportunities abound.